Outside the Box: These 5 factors could stop the stock market’s rally cold

The stock market’s snap-back so far this year — which I suggested might play out here — has been nice to say the least, especially if you are in small caps.

The Russell 2000

RUT, -0.24%

has advanced 6.7% this year through Wednesday compared to 3.1% for the SP 500

SPX, +0.04%

and 2.4% for the Dow Jones Industrial Average

DJIA, +0.16%

.

The market goes still goes higher in my view.

But it’s certainly not a given. In fact, for the stocks to continue higher, we need five developments to play out — and some of them very soon. That means the next few weeks. Otherwise, the selling in stocks will resume. Here’s what to watch for.

The war on trade

Business managers around the world have been forced to divert attention from running their companies to finding contingencies for their China supply chains. That’s not good. Big picture, tariffs are generally bad for economies and growth since they hinder trade. Trade helps growth because it allows each country to focus on what it does best.

Besides, tariffs are essentially are a form of government intervention that sets up protected industries. This lack of competition creates laziness and inefficiencies.

All of this explains why the prospect of higher tariffs and a trade war are weighing on growth in China, the U.S. and elsewhere. Investors got a reprieve when the White House said it would delay hiking tariffs on Chinese goods until March so as to allow more room for negotiation.

Now it’s time for trade negotiators to come through with the goods. Otherwise the stock market rally will peter out.

“This is huge,” cautions Bear Traps Report author Larry McDonald, who has made several good market calls over the past few years based in part on his macro analysis.

“If they kick the can and don’t give any clarity on when they are going to end this, the market is not going to like it,” he says. Given the tight March deadline, we need a resolution soon. Otherwise investors will lose faith in the prospects for a trade truce. “We need to hear something in the next 10 to 20 days, or the market is going to roll over hard,” he says.

The Fed

Investors cheered when Fed Chair Jerome Powell signaled a reversal of plans for aggressive rate hikes in 2019, and flexibility on quantitative tightening (the reduction of Treasury position on the Fed balance sheet).

Now the Fed needs to stay on this course and continue to reassure investors that’s the plan. If the Fed signals otherwise, that will be a big problem for stocks. Worries about a recession will come back. Any kind of ambiguity on this front is the equivalent of the Fed “smoking in the dynamite shed,” says McDonald.

“The central question now facing markets is whether the Fed is merely tweaking its message or is preparing to halt the tightening cycle altogether,” he says. The latter would boost stocks. It would also weaken the dollar — which would be bullish for gold, oil commodities and emerging markets.

Read: Fed chatter confirms interest rates on hold until May at earliest

High-yield deals

The junk bond market essentially shut down in December. Given the huge amount of junk debt that lower-quality companies took on in the past few years — and the large amount coming due soon — this market needs to reopen soon. Or bankruptcies will skyrocket. That won’t be good for the stock market and investor sentiment.

Junk-bond maturities soar this year, which means companies have a lot of debt to roll over. They won’t be able to do so in a frozen market for high-yield credit.

Junk maturities jump to $110 billion this year and $191 billion in 2020, compared to $36 billion last year, points out McDonald, citing data from Moody’s Investors Service. It gets even worse after that. In 2021 there will be $293 billion worth to roll over, and then $385 billion in 2022. These numbers represent leveraged loan and high-yield bond maturities.

“Leverage is a very dangerous beast. The larger it becomes the more perfection it demands in capital markets functionality,” says McDonald. “If capital market formation stays challenged, that will lead to a colossal default spike of unprecedented proportions.” And investor panic, which will tank stocks.

Performance of riskier debt

You can monitor this by tracking how exchange-traded funds of riskier debt perform compared to an investment-grade debt ETF like the iShares iBoxx $ Investment Grade Corporate Bond ETF

LQD, -0.24%

So watch how ETFs like Invesco Senior Loan

BKLN, -0.11%

(leveraged loans), iShares iBoxx $ High Yield Corporate Bond

HYG, +0.05%

and SPDR Bloomberg Barclays High Yield Bond

JNK, +0.12%

trade. You’ll want to see them going up as much as — or more than — the investment-grade ETF above.

Read: Half of investment-grade bonds are only one step away from junk status

The VIX futures curve

Contrarians like me normally follow the VIX fear gauge as a measure of investor sentiment — to know when to buy because everyone else is panicking. Typically, a spike in the VIX to 35-40 is a good contrarian buy signal, as it was in late December.

But more nuanced VIX-related intelligence comes from the VIX futures curve. When near months are more expensive than out months, it’s another sign of heightened investor fear. It means investors are paying up for near-term protection. This is called backwardation of the futures curve.

Coming out of a bear market or capitulation, however, you no longer want to use the VIX futures curve as a contrarian gauge of investor sentiment. Instead, the key is to watch the VIX futures curve for signals that investor confidence is solid enough to support a sustained rally, says McDonald. He likes to see the price of VIX futures contracts two months out cheaper than the futures price eight months out by about $1. “That is when the rally is sustainable. That’s what history tells us.”

Right now, this part of the VIX futures curve is moving back toward this shape, but it is not there yet. You can track the VIX futures curve here and here.

At the time of publication, Michael Brush had no positions in any ETFs mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.

Michael Brush is a Manhattan-based financial writer who publishes the stock newsletter Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group. He attended Columbia Business School in the Knight-Bagehot program.